Investor Psychology Series Chapter 3: Heuristic Simplification - Misuse of information
Heuristics in cognitive psychology can be defined as shortcutting or the use of rule of thumb decision making, especially under conditions of uncertainty.
To put this another way, humans use heuristics to navigate social and professional situations basically instinctively. For example, we know the social norms in a social setting and use these ‘rules of thumb’ to mould our behaviour to fit in.
Heuristics may be good for human interactions; however, they are not good when assessing high levels of information quickly, or when under stress. This can lead to an oversimplification or the misuse of information.
There are four parts to heuristic simplification:
Anchoring is when an investor holds an investment belief and then applies this anchor point as a subjective reference for making future judgments.
As heuristics suggest, the populace often base decisions on the first source of information to which they are exposed. So, just like when we make judgements about people on meeting them for the first time; in investing the initial purchase price (too expensive or too cheap), for example, can anchor our view and lead to difficulty adjusting our views as new information comes to hand.
What is even more interesting about the anchoring phenomenon in behavioural finance is the round number effect which sees a disproportionate level of interest, like the ASX hitting 6000 points or the Dow Jones breaking 33,000. This anchors people’s view and can promote behaviour that is contrary to their wants and goals.
Representativeness bias in behaviour finance is when an investor labels an investment as good or bad based on its recent performance. This means they will buy securities after prices have risen as they expect those increases to continue while ignoring securities that have fallen below their intrinsic values.
Representative bias also leads people to use past experiences to arrive at results too quickly and with imprecise information. A prime example in investing is using a strong half or full year earnings announcement from the past to assume the next earnings announcement will be just as strong in the future – think the Australian Big 4 banks from 2013-2017 versus results of the past three years.
The behaviour known as the gambler’s fallacy is the belief of seeing patterns where none exist. It relates to the cognitive desire people (investors) have to impose a structure on things that are actually random. The term gambler’s fallacy was coined from observing gamblers who believe that a string of good luck will follow a string of bad luck in a casino setting.
Taking that further, a study by Daniel Kahneman into pattern behaviours posed this question to participants, ‘which of the following sequences is more likely to occur when a coin is flipped – HHHTTT or HTHTTH?’ The majority overwhelmingly said the second sequences as the first is perceptive to not be a random sequence, which is false as this outcome is just as likely as the second. This happens because the mind seeks patterns and is quick to identify interconnections in events.
In the context of investing, it can cause investors to perceive trends where none exist, and to take action on these inaccurate impressions.
Under free market theory, buying and selling an investment occurs due to the same signals evenly influencing a buy or sell decision. However, several studies have found that individual investors are more likely to buy rather than sell securities that catch their attention. This is especially true when these securities are mentioned in the media, have abnormal amounts of trading volumes or the security has an extreme one day move.
Attention bias arises on the buy side of investing more because it requires investors to sift through thousands of investment options but are limited by how much information they can actually process before buying.
The sell side doesn’t face this problem because investors tend to only sell securities they already own. The issue with attention bias is these attention-based purchases can lead to disappointing returns or even loss, as the attention event can be a one off or a false reason to invest in the first place.